Subordinated Loan

What is a “Subordinated Loan”?

A subordinated loan refers to debt that ranks below more senior loans or securities in a company’s capital stack with regards to claims on assets and earnings. A subordinated loan is also known as subordinated debt, subordinated debenture, and junior debt. Subordinated debt holders receive payment after the senior debt has been fully settled in the event of a liquidation. High yield bonds and mezzanine debt are two examples of subordinated loans. Credit agencies carefully evaluate the default risk of subordinated loans and assign a credit score accordingly.

Understanding Subordinated Loans

A subordinated loan is any type of loan which is repaid only after the senior debt has been fully repaid in a situation where a borrower defaults on their loan obligations. Subordinated loans are risker than senior loans and therefore command a higher interest rate.

To better understand subordinated loans, it is essential to review the capital stack. A company’s capital stack ranks the various sources of capital in order of priority, starting with senior debt (unsubordinated debt), subordinated loan, and equity. This hierarchy also shows that shareholders have the highest return profile, followed by subordinated debt creditors and senior debt holders, reflecting the nature of the risk borne. In the event of liquidation, unsubordinated debt creditors will be paid first, and shareholders will only be paid after all debt creditors have been paid.

If a company files for bankruptcy, a bankruptcy court will prioritize loan repayments using the company’s assets, starting from unsubordinated loan creditors followed by subordinated loan creditors and ending with shareholders. Subordinated loan creditors may receive only partial payment or none depending on the level of excess cash left after repaying unsubordinated loan creditors.

Given the risks related to subordinated loans, potential investors must consider the issuing company’s solvency, its other debt obligations, and the total assets when deciding whether to lend or not. Subordinated loan holders can realize higher interest rates in compensation for the risks involved in a potential default scenario and will be repaid before any equity holders.

Features of Subordinated Loans

When a corporation takes out debt, it may issue out various types of bonds which are either unsubordinated or subordinated loans. There is a wide variety of subordinated debt financing instruments, each with different priorities. Some examples of subordinated loans include high yield bonds, mezzanine with and without warrants, Payment in Kind (PIK) notes, and vendor notes, all in order of priority from highest to lowest.

To examine the features of subordinated loans, we will consider two types, namely high yield bonds and mezzanine finance. High yield bonds are publicly traded securities that permit the holders to exchange them in secondary market transactions. Mezzanine loans, on the other hand, are not tradeable.

Credit rating agencies assign high yield bonds credit scores to guide potential investors interested in purchasing these bonds. The credit scores on high yield bonds are based on the rating agency’s default risk evaluation. Bonds with an AAA rating are the most attractive and secure with the least probability of default, while bonds with a D rating are the least secure with the highest probability of default. For a bond to be regarded as investment grade, it needs to have a credit score of BBB- and above, while any bonds with credit scores of BB+ and below are considered as non-investment grade, high yield, or junk bonds. The principal rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch.

A mezzanine loan is a non-tradeable debt that is subordinated to senior debt. It is usually characterized by bullets repayments, accrued cash returns, and equity warrants. Equity warrants offer lenders exposure to equity upside on top of the expected return on the actual interest payments. Mezzanine loans may also include convertible loan stocks, which can convert entirely into equity, or convertible preference shares, which can also be converted into preference shares. Convertible preference shares, convertible loan stocks, and loans with warrants all offer in-built exposures to equity.

In terms of return, mezzanine loan lenders target an Internal Rate of Return (IRR) of 15% to 20% and consists of many components. The first two components are contractual returns which the company owes to the investor. Firstly, the actual cash interest is paid to the investor by the borrowing company. Secondly, the accrued interest is the interest accrued to be repaid along with the principal. The third and last component is the upside exposure to equity from warrants, typically 3% to 10% of the post-exit value of the business. All three components significantly increase the IRR of a subordinated loan investor.

Conclusion

The risky nature of subordinated loans lies in the fact that there is little or no guarantee that they will be paid back in full. Investors interested in lending these loans to companies must examine the company’s total assets, its other debt obligations, and the ability of the company to meet its long-term debt and financial obligations before making its decision. As attractive as the high-interest rates may be, the probability of default caused by bankruptcy or liquidation and its implication on subordinated loan creditors should be vital when purchasing these loans.

Below is a multiple-choice question to test your knowledge. Download the accompanying excel file for a full explanation of the correct answer.